THE CIRCULAR FLOW MODEL with Government

In the following figure we have integrated government. What have changed?

Flows (5) through (8) illustrate that government make purchases in resource and product market. Flows (5) and (6) represent buying of products, but (7) and (8) represent buying of resource by government.

Government shall have money to pay its members, teachers, police, inspectors, bus drivers, doctors, fire fighters etc. Government might buy land to build a new school, expand a hospital.

Government offers public goods and services to both households and businesses, as shown by (9) and (10). Government gets paid for these goods and services by collecting taxes by flows (11) and (12).  Flow (11) represents different subsidies to airlines, doctors which are then paid back to government, because most of them are low-interest loans, taxes, or public facilities provided at prices below their real price. Flow (12) includes taxes collected by government from households and different kind of social insurance benefits offered by government. The structure of taxes and transfer payments affects income distribution. In flow (12), taxes drawn from “rich” households, combined with a system of transfer payments to low-income households, reduces income inequality.

Flows (5) through (8) imply that government takes away resources from private sector or use,  and directs them to constructing public goods. This resource reallocation is required for producing public goods and services.